EXTERNALITIESWHAT’S NEW IN THE THIRD EDITION:The section on externalities is simplified, with an emphasis solely on the distinction between positive and negative externalities.LEARNING OBJECTIVES:By the end of this chapter, students should understand:what an externality is.why externalities can make market outcomes inefficient.how people can sometimes solve the problem of externalities on their own.why private solutions to externalities sometimes do not work.the various government policies aimed at solving the problem of externalities.CONTEXT AND PURPOSE:Chapter 10 is the first chapter in the microeconomic section of the text. It is the first chapter in a three-chapter sequence on the economics of the public sector. Chapter 10 addresses externalities—the uncompensated impact of one person’s actions on the well-being of a bystander. Chapter 11 will address public goods and common resources (goods that will be defined in Chapter 11) and Chapter 12 will address the tax system.In Chapter 10, different sources of externalities and a variety of potential cures for externalities are addressed. Markets maximize total surplus to buyers and sellers in a market. However, if a market generates an externality (a cost or benefit to someone external to the market) the market equilibrium may not maximize the total benefit to society. Thus, in Chapter 10 we will see that while markets are usually a good way to organize economic activity, governments can sometimes improve market outcomes.198 Chapter 10/ExternalitiesKEY POINTS:1. When a transaction between a buyer and seller directly affects a third party, that effect is called an externality. Negative externalities, such as pollution, cause the socially optimal quantity in a marketto be less than the equilibrium quantity. Positive externalities, such as technology spillovers, cause the socially optimal quantity to be greater than the equilibrium quantity.2. Those affected by externalities can sometimes solve the problem privately. For instance, when one business confers an externality on another business, the two businesses can internalize theexternality by merging. Alternatively, the interested parties can solve the problem by negotiating a contract. According to the Coase theorem, if people can bargain without cost, then they can always reach an agreement in which resources are allocated efficiently. In many cases, however, reaching a bargain among the many interested parties is difficult, so the Coase theorem does not apply.3. When private parties cannot adequately deal with external effects, such as pollution, the government often steps in. Sometimes the government prevents socially inefficient activity by regulating behavior.Other times it internalizes an externality using Pigouvian taxes. Another way to protect the environment is for the government to issue a limited number of pollution permits. The end result of this policy is largely the same as imposing Pigouvian taxes on polluters.CHAPTER OUTLINE:I.Definition of externality: the unc ompensated impact of one person’s actions on the well-being of a bystander.A. If the effect on the bystander is adverse, we say that there is a negative externality.B. If the effect on the bystander is beneficial, we say that there is a positive externality.C.In either situation, decisionmakers fail to take account of the external effects of their behavior.II. Externalities and Market InefficiencyA. Welfare Economics: A Recap1. The demand curve for a product reflects the value of that product to consumers,measured by the price that buyers are willing to pay.Chapter 10/Externalities 1992. The supply curve for a product reflects the cost of producing the product.3. In a free market, the price of a good brings supply and demand into balance in away that maxim izes total surplus (the difference between the consumers’valuation of the good and the sellers’ cost of producing it).B. Negative Externalities1. Example: an aluminum firm emits pollution during production.ALTERNATIVE CLASSROOM EXAMPLE:A coal-fired power plant.200 Chapter 10/Externalities2. Social cost is equal to the private cost to the firm of producing the aluminumplus the external costs to those bystanders affected by the pollution. Thus,social cost exceeds the private cost paid by producers.3. The optimal amount of aluminum in the market will occur where total surplus ismaximized.a. Total surplus is equal to the value of aluminum to consumers minus thecost (social cost) of producing it.b. This will occur where the social cost curve intersects with demand curve.At this point, producing one more unit would lower total surplus becausethe value to consumers is less than the cost to produce it.4. Because the supply curve does not reflect the true cost of producing aluminum,the market will produce more aluminum than is optimal.5. This negative externality could be internalized by a tax on producers for eachunit of aluminum sold.6. Definition of internalizing an externality: altering incentives so thatpeople take account of the external effects of their actions.Chapter 10/Externalities 201202 Chapter 10/ExternalitiesC. Positive Externalities1. Example: education.2.Education yields positive externalities because a better educated population leads to a better government.3. In this case, the demand curve does not reflect the social value of a good.4. If there is a positive externality, the social value of the good is greater than theprivate value, and the optimum quantity will be greater than the quantity produced in the market.5.To internalize a positive externality, the government could again use a subsidy.ALTERNATIVE CLASSROOM EXAMPLE:The purchase of a fire extinguisher when an individual lives in an apartment.Chapter 10/Externalities 2036. Case Study: Technology Spillover and Industrial Policya. It is difficult to measure the amounts of technology spillover that occurand this leads to a debate over whether or not the government shouldpursue policies to encourage the production of technology.b. Patent protection is a type of technology policy of the governmentbecause it protects the rights of inventors who create new technologies.Without patents, there would be less incentive to develop new ideas andtechnologies.III. Private Solutions to ExternalitiesA. We do not necessarily need government involvement to correct externalities.B. The Types of Private Solutions1. Problems of externalities can sometimes be solved by moral codes and socialsanctions.a. Do not litter.b. The Golden Rule.2. Many charities have been established that deal with externalities.a. Sierra Club (environment).b. University Alumni Association (scholarships).204 Chapter 10/Externalities3. The parties involved in this externality (either the seller and the bystander or theconsumer and the bystander) can possibly enter into an agreement to correctthe externality.C. The Coase Theorem1. Definition of coase theorem: the proposition that if private parties canbargain without cost over the allocation of resources, they can solvethe problem of externalities on their own.2. Example: Dick owns a dog that disturbs a neighbor (Jane) with its barking.a. One possible solution to this problem would be for Jane to pay Dick toget rid of the dog. The amount that she would be willing to pay wouldbe equal to her valuation of the costs of the barking. Dick would onlyagree to this if Jane paid him an amount greater than the value heplaces on owning Spot.b. Even if Jane could legally force Dick to get rid of Spot, another solutioncould occur. Dick could pay Jane to let him keep the dog.3. Whatever the initial distribution of rights, the parties involved in an externalitycan solve the problem themselves and reach an efficient outcome where bothparties are better off.D. Why Private Solutions Do Not Always Work1. Definition of transaction costs: the costs that parties incur in the processof agreeing and following through on a bargain.2. Coordination of all of the interested parties may be difficult so that bargainingbreaks down. This is especially true when the number of interested parties islarge.IV. Public Policies toward ExternalitiesA. When an externality causes a market to reach an inefficient allocation of resources, thegovernment can respond in two ways.1. Command and control policies regulate behavior directly.2. Market-based policies provide incentives so that private decisionmakers willchoose to solve the problem on their own.B. Regulation1. Externalities can be corrected by making certain behaviors either required orforbidden.Chapter 10/Externalities 2052. In the United States, it is the Environmental Protection Agency (EPA) thatdevelops and enforces regulations aimed at protecting the environment.3. EPA regulations include maximum levels of pollution allowed or required adoptionof a particular technology to reduce emissions.C. Pigovian Taxes and Subsidies1. Externalities can be internalized through the use of taxes and subsidies.2. Definition of Pigouvian tax: a tax enacted to correct the effects of anegative externality.a. These taxes are preferred by economists over regulation, because firmsthat can reduce pollution with the least cost are likely to do so (to avoidthe tax) while firms that encounter high costs when reducing pollutionwill simply pay the tax.b. Thus, this tax allows firms that face the highest cost of reducingpollution to continue to pollute while encouraging less pollution over all.c. Unlike other taxes, Pigouvian taxes do not cause a reduction in totalsurplus. In fact, they increase economic well-being by forcingdecisionmakers to take into account the cost of all of the resources beingused when making decisions.3. Case Study: Why is Gasoline Taxed So Heavily?a. In the United States, almost half of what drivers pay for gasoline goes togas taxes.b. This is to correct for three negative externalities associated with driving:congestion, accidents, and pollution.C. Tradable Pollution Permits1. Example: EPA regulations restrict the amount of pollution that two firms can emitat 300 tons of glop per year. Firm A wants to increase its amount of pollution.Firm B agrees to decrease its pollution by the same amount if Firm A pays it $5million.2. Social welfare is increased if the EPA allows this situation. Total pollutionremains the same so there are no external effects. If both firms are doing thiswillingly, it must make them better off.3. If the EPA issued permits to pollute and then allowed firms to sell them, thiswould also increase social welfare. Firms that could control pollution mostinexpensively would do so and sell their permits, while those who encounter highcosts when reducing pollution would buy additional permits.206 Chapter 10/Externalities4.Tradable pollution permits and Pigouvian taxes are similar in effect. In both cases, firms must pay for the right to pollute. a.In the case of the tax, the government basically sets the price of pollution and firms then choose the level of pollution (given the tax) that maximizes their profit.b. If tradable pollution permits are used, the government chooses the level of pollution (in total, for all firms) and firms then decide what they arewilling to pay for these permits.D. Objections to the Economic Analysis of Pollution1. Some individuals dislike the idea of allowing companies to purchase the right topollute.2. These people fail to understand that the United States has limited ability toeliminate pollution and such elimination would come at a high opportunity cost. 3.Economists point out that ―people face tradeoffs‖ (Principle #1) and we must decide how much we would be willing to give up to have no pollution. It would likely not be enough.E. In the News: Children As ExternalitiesStress to students that the socially opti mal level of pollution is not ―zero.‖ Make sure that they understand that society faces a tradeoff because of the resources used to combat pollution.Figure 4Chapter 10/Externalities 2071. Noisy children, especially crying babies on an airplane, may be viewed as anegative externality.2. This is a tongue-in-cheek editorial from The Economist concerning this issue.SOLUTIONS TO TEXT PROBLEMS:Quick Quizzes1. Examples of negative externalities include pollution, barking dogs, and consumption of alcoholicbeverages (many others are possible). Examples of positive externalities include restoringhistoric buildings, research into new technologies, and education (many others are possible).Market outcomes are inefficient in the presence of externalities because markets produce a larger quantity than is socially desirable when there is a negative externality and a smaller quantity than is socially desirable when there is a positive externality.2. Examples of private solutions to externalities include moral codes and social sanctions, charities,relying on the self-interest of the relevant parties, and entering contracts.The Coase theorem is the proposition that if private parties can bargain without cost over theallocation of resources, they can solve the problem of externalities on their own.Private economic actors are sometimes unable to solve the problems caused by an externalitybecause of transactions costs, because bargaining breaks down, or when the number ofinterested parties is large so that coordinating everyone is costly.3. The town government might respond to the externality from the smoke in three ways: (1)regulation; (2) Pigovian taxes; or (3) tradable pollution permits.Regulation prohibiting pollution beyond some level is good because it is often effective atreducing pollution. But doing so successfully requires the government to have a lot ofinformation about the industries and about the alternative technologies that those industriescould adopt.Pigovian taxes are a useful way to reduce pollution because the tax can be increased to getpollution to a lower level and because the taxes raise revenue for the government. The tax ismore efficient than regulation because it gives factories economic incentives to reduce pollution and to adopt new technologies that pollute less. The disadvantage of Pigovian taxes is that the government needs to know a lot of information to pick the right amount to tax.Tradable pollution permits are similar to Pigovian taxes but allow the firms to trade the right topollute with each other. As a result, the government does not need as much information about the firms’ technol ogy. The government can simply set a limit on the total amount of pollution,issue permits for that amount, and allow the firms to trade the permits, thus reducing pollutionwhile allowing economic efficiency. The disadvantage of pollution permits is that the government may not set the right overall level of pollution.208 Chapter 10/ExternalitiesQuestions for Review1. Examples of negative externalities include pollution, barking dogs, and consumption of alcoholicbeverages (many others are possible). Examples of positive externalities include restoringhistoric buildings, research into new technologies, and education (many others are possible).2. Figure 1 illustrates the effect of a negative externality. The equilibrium quantity provided by themarket is Q market. Because of the externality, the social cost of production is greater than theprivate cost of production, so the social-cost curve is above the supply curve. The optimalquantity for society is Q optimum. The private market produces too much of the good, as Q market is greater than Q optimum.Figure 13. The patent system helps society solve the externality problem from technology spillovers. Bygiving inventors exclusive use of their inventions for a period of time, the inventor can capturemuch of the economic benefit of the invention. In doing so, the patent system encouragesresearch and technological advance, which benefits society through spillover effects.4. Externalities can be solved without government intervention through moral codes and socialsanctions (which tell us to internalize externalities, such as not to litter), charities (donations to organizations like the Sierra Club to protect the environment or to universities to supporteducation), merging firms whose externalities affect each other (for example, the apple grower and the beekeeper), or by contract.5. According to the Coase theorem, you and your roommate will bargain over whether yourroommate will smoke in the room. If you value clean air more than your roommate valuessmoking, the bargaining process will lead to your roommate not smoking. But if your roommate values smoking more than you value clean air, the bargaining process will lead to your roommate smoking. The outcome is efficient as long as transaction costs do not prevent an agreementfrom taking place. The solution may be reached by one of you paying off the other either not to smoke or for the right to smoke.Chapter 10/Externalities 2096. Pigovian taxes are taxes enacted to correct the effects of a negative externality. Economistsprefer Pigovian taxes over regulations as a way to protect the environment from pollutionbecause they can reduce pollution at a lower cost to society. A tax can be set to reduce pollution to the same level as a regulation. The tax has the advantage of letting the market determine the least expensive way to reduce pollution. The tax gives firms incentive to develop cleanertechnologies to reduce the taxes they have to pay.Problems and Applications1. The Club conveys a negative externality on other car owners because car thieves will not attemptto steal a car with The Club visibly in place. This means that they will move on to another car.The Lojack system conveys a positive externality because thieves do not know which cars havethis technology. Therefore, they are less likely to steal any car. Policy implications include asubsidy for car owners that use the Lojack technology and a tax on those who use the Club.2. a. The statement, "The benefits of Pigovian taxes as a way to reduce pollution have to beweighed against the deadweight losses that these taxes cause," is false. In fact,Pigovian taxes reduce the inefficiency of pollution by reducing the quantity of the goodbeing produced that has pollution as a by-product. So, Pigovian taxes reducedeadweight loss, they do not increase it.b. The statement, "When deciding whether to levy a Pigouvian tax on consumers orproducers, the government should be careful to levy the tax on the side of the marketgenerating the externality" is inaccurate. It does not matter on whom the tax isimposed the incidence of the tax will be identical. So whether the externality is causedby the seller or the buyer of a good, a tax on either producers or consumers will lead tothe same reduction of quantity and change in the prices producers receive or consumerspay.Figure 2210 Chapter 10/Externalities3. a. Fire extinguishers exhibit positive externalities because even though people buy them fortheir own use, they prevent may fire from damaging the property of others.b. Figure 2 illustrates the positive externality from fire extinguishers. Notice that the socialvalue curve is above the demand curve and the social cost curve is the same as thesupply curve.c. The market equilibrium level of output is denoted Q market and the efficient level of outputis denoted Q optimum. The quantities differ because in deciding to buy fire extinguishers,people don't account for the benefits they provide to other people.d. A government policy that would result in the efficient outcome would be to subsidizepeople $10 for every fire extinguisher they buy. This would shift the demand curve up tothe social value curve, and the market quantity would increase to the optimum quantity.4. Charitable organizations are most often organized to deal with externalities. By letting charitablecontributions be deductible under the federal income tax, the government provides a tax subsidy to charity, thus encouraging private solutions to the externality. People can give to theorganization that they feel provides the most benefit to society, so the tax subsidy may be more effective than if the government itself tried to solve the externality. For example, churches may be better at helping the needy than government welfare programs.5. a. The externality is noise pollution. Ringo’s consumption of rock and roll music affectsLuciano, but Ringo does not take that into account in deciding how loud he plays hismusic.b. The landlord could impose a rule that music could not be played above a certain decibellevel. This could be inefficient because there would be no harm done by Ringo playinghis music loud if Luciano is not home.c. Ringo and Luciano could negotiate an agreement that might, for example, allow Ringo toplay his music loud at certain times of the day. They might not be able to reach anagreement if the transactions costs are high or if bargaining fails because each holds outfor a better deal.5. If the Swiss government subsidizes cattle farming, it must be because there are externalitiesassociated with it. Since tourists come to Switzerland to see the beautiful countryside,encouraging farms, as opposed to industrial development, is important to maintaining the tourist industry. Thus farms produce a positive externality by keeping the land beautiful and unspoiled by development. The government's subsidy thus helps the market provide the optimal amount of farms.6. a. The market for alcohol is shown in Figure 3. The social value curve is below the demandcurve because of the negative externality from increased motor vehicle accidents causedby those who drink and drive. The free-market equilibrium level of output is Q market andthe efficient level of output is Q optimum.b. The triangular area between points A, B, and C represents the deadweight loss of themarket equilibrium. This area shows the amount by which social costs exceed socialvalue for the quantity of alcohol consumption beyond the efficient level.Chapter 10/Externalities 211Figure 38. a. It is efficient to have different amounts of pollution reduction at different firms becausethe costs of reducing pollution differ across firms. If they were all made to reducepollution by the same amount, the costs would be low at some firms and prohibitive atothers, imposing a greater burden overall.b. Command-and-control approaches that rely on uniform pollution reduction among firmsgive the firms no incentive to reduce pollution beyond the mandated amount. Instead,every firm will reduce pollution by just the amount required and no more.c. Pigovian taxes or tradable pollution rights give firms greater incentives to reducepollution. Firms are rewarded by paying lower taxes or spending less on permits if theyfind methods to reduce pollution, so they have the incentive to engage in research onpollution control. The government does not have to figure out which firms can reducepollution the most it lets the market give firms the incentive to reduce pollution on theirown.9. a. If the government knew the cost of reduction at each firm, it would have Acme eliminateall its pollution (at a cost of $10 per ton times 100 tons = $1,000) and have Creativeeliminate half of its pollution (at a cost of $100 per ton times 50 tons = $5,000). Thisminimizes the total cost ($6,000) of reducing the remaining pollution to 50 tons.b. If each firm had to reduce pollution to 25 tons (so each had to reduce pollution by 75tons), the cost to Acme would be 75 x $10 = $750 and the cost to Creative would be 75x $100 = $7,500. The total cost would be $8,250.212 Chapter 10/Externalitiesc. In part a, it costs $6,000 to reduce total pollution to 50 tons, but in part b it costs $8,250.So it is definitely less costly to have Acme reduce all of its pollution and have Creative cutits pollution in half. Even without knowing the costs of pollution reduction, thegovernment could achieve the same result by auctioning off pollution permits that wouldallow only 50 tons of pollution. This would ensure that Acme reduced its pollution tozero (since Creative would outbid it for the permits) and Creative would then reduce itspollution to 50 tons.10. A Pigouvian tax can be used when an externality is present to force the parties to internalize theexternality. This, in effect, is a fine for doing something "wrong" (that generates a negativeexternality). On the other hand, individuals and firms who do something "right" (such as workmore hours, earn a higher income, earn greater profits) are generally taxed more. This is, ineffect, a fine for succeeding. Unlike the Pigouvian tax, this type of taxation reduces theefficiency of the market.11. a. An improvement in the technology for controlling pollution would reduce the demand forpollution rights, shifting the demand curve to the left. Figure 4 illustrates what wouldhappen if there were a Pigovian tax, while Figure 5 shows the impact if there were afixed supply of pollution permits. In both figures, the curve labeled D1 is the originaldemand for pollution rights and the curve labeled D2 is the new demand for pollutionrights after the improvement in technology.Figure 4b. With a Pigovian tax, the price of pollution remains unchanged and the quantity ofpollution declines, as Figure 4 shows. With pollution permits, the price of pollutiondeclines and the quantity of pollution is unchanged, as Figure 5 illustrates.Chapter 10/Externalities 213Figure 512. a. In terms of economic efficiency in the market for pollution, it does not matter if thegovernment distributes the permits or auctions them off, as long as firms can sell thepermits to each other. The only difference would be that the government could makemoney if it auctioned the permits off, thus allowing it to reduce taxes, which would helpreduce the deadweight loss from taxation. There could also be some deadweight lossoccurring if firms use resources to lobby for additional permits.b. If the government allocated the permits to firms who did not value them as highly asother firms, the firms could sell the permits to each other so they would end up in thehands of the firms who value them most highly. Thus the allocation of permits amongfirms would not matter for efficiency. But it would affect the distribution of wealth, sincethose who got the permits and sold them would be better off.13. a. International cooperation is needed because the externality from global warming isworldwide, so the benefits from solving the problem are worldwide. Further, theefficient solution to the problem involves minimizing the costs to society; in this case,society means the entire world.b. Since it would be efficient to reduce carbon dioxide most in countries where the costs ofreducing carbon dioxide emissions are low, some compensation scheme needs to be putin place to encourage the reduction of emissions. One possibility would be to monitoremissions, taxing those countries whose emissions are high and using the proceeds tosubsidize those who reduce their emissions. This gives the incentive to reduce emissionsin those areas where the cost of doing so is the least. In countries where the cost ofreducing emissions is high, they will just pay the tax. A system of uniform emissionreductions would impose high costs on some countries and low costs on others, andwould not give anyone the incentive to reduce emissions beyond the mandated amount.14. All activities, including reducing pollution, involve opportunity costs. Under command-and-controlpolicies, there is an opportunity cost in terms of the resources that firms must use to reducepollution. Using market-based methods merely recognizes that fact and gives firms economicincentives to reduce pollution, thus reducing the costs of reducing pollution. Since market-based。
